What a difference a week can make in markets. Just a week ago, robust global growth, low inflation and a weakening US dollar acted as powerful forces to support risk spirits and a deep rally across risky assets.
What a difference a week can make in markets. Just a week ago, robust global growth, low inflation and a weakening US dollar acted as powerful forces to support risk spirits and a deep rally across risky assets. With the benefit of hindsight as a powerful guide, complacency permeating capital markets was excessive and quickly reversed as investors started to discount the impact of rapidly increasing interest rates during a late phase of a market cycle.
For a risk parity strategy a scenario of simultaneous falls in growth sensitive and more defensive assets (cash outperforming both equities and bonds) can be the perfect storm. For a long time now we have cited the danger of assuming that equities and bonds remain negatively correlated when inflation pressures mount. A simple present-value analysis based on discounted cash flows suggests that as inflation increases, ceteris paribus – that is, the real present value of everything must fall.
The danger that such a scenario represents in an otherwise well diversified portfolio leads us to own some exposures that are expected to act as “insurance” against rapidly rising inflation expectations; assets whose future cash flows are directly or indirectly linked to inflation such as inflation swaps or commodities. We complement this approach with a more subtle form of insurance, making sure we don’t rely too heavily on the diversification benefit of bonds through our risk model and through incorporation of valuation tilts which at present reduce our allocation to bond markets.
As risky assets digested the (still) favorable growth backdrop, having rallied hard through the end of 2017 and January 2018, a conservative and highly diversified view of the world leads to less participation in the growth concentrated rally. However this approach is now realizing some benefits, by retaining less directional sensitivity during this week’s volatility. As the dust settles on the recent sell-off and bond yields stabilize at new highs, we are likely to gradually unwind some of these tilts in anticipation of more “normal” equity-bond relationships moving forward. For now we are not out of the woods, and capital preservation remains a key focus.
Next week’s US data releases could calm markets or whip up more of a storm; CPI expectations are already quite conservative at 0.5% for January (as announced today), creating a meaningful hurdle. On balance, we believe that markets have now discounted the inflationary risk and the narrative has certainly moved a long way in the direction that we started discussing with our investors almost three months ago. However, a surprise is a surprise and with this uncertainty ahead and all investors on high alert, we remain cautious, running at a relatively lower risk. For now, all of the porridge is a bit too hot for us!
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.